The magnitude of the current economic crisis makes it abundantly clear that there is significant room, and need, for improvement in current credit assessment approaches. With fallout from the 2007 mortgage market problems lingering into 2008, large investment banks and other institutions have being forced to sharply increase their write-offs on mortgage-linked assets to the scale of tens of billions of dollars. As the subprime mortgage market crisis continues to unfold, lenders, investors and other market participants are exploring cause and cure of the subprime problems, especially in the area of credit scoring models.
Credit scoring models have been extensively used in consumer lending to assist a wide range of decision-making process associated with both loan underwriting and pricing. Automated consumer credit scoring models have made it possible for lenders to process far more applications in a shorter period of time than was possible when manual loan underwriting processes were used. Furthermore, credit scoring has proven to be more efficient, objective, consistent, cost-effective, and transparent than the systems they have replaced. As a result, this has significantly improved the efficiency, fairness, and accessibility of the mortgage market.
Credit models are necessarily complex because the business processes and policy rules that they embody, for both underwriting and pricing, are fairly intricate. For example, they have to ensure their credit risk models are in line with consumer protection regulations governing lending practices, so as to minimize the risk of compliance violations.
Regulators and policymakers recognize the potential for misapplication, or misspecification, of credit models. Problems can occur at any point in the modeling process, including data gathering, data cleansing, observation selection, formulation of model assumptions, sourcing of business rules, actual model specification, model validation, model deployment, model execution, model monitoring, model maintenance, and model re-development. Even if the model is correct, care must be given to ensure that the proper model is used for the appropriate segment of business and that model performance is maintained at acceptable levels. Substandard performance in one or more of these areas can lead to regulatory actions that can affect the institution's credit ratings and capital requirements